Credit Suisse analyst Michael Dahl has upgraded the luxury home builder from neutral to outperform with a $42 price target, arguing that the Street underestimates the earnings story in 2016, forecasting sharply higher deliveries from the “city living” unit and rising prices in California.

At $37.44, the stock rose 1.7% today, a bright spot in a volatile year for the stock.

Toll made news in 2013 when it moved from the burbs to the big city. The builder behind the “McMansion” has been pushing to become a name in the nation’s luxury condominium market.

Dahl sees that mix shift expanding gross margins next year. As he writes:

Consensus is likely underestimating the swell of City Living deliveries: We expect City Living revs to rise by ~150% in ’16 to $573 mln from $227 mln in ’15. Assuming traditional homebuilding gross margins are flat in ’16, we est. the mix benefit from higher City Living revs will drive consolidated GM expansion of 85 bps y/y (to 23.4% from 22.5%). For context, City Living GM has expanded from 34.3% (’13) to 41.5% (’14) and is ~47% ytd in ’15. We expect it will continue to generate 40%+ GMs at least through ’16 as TOL delivers on attractively underwritten property which has benefitted from significant price appreciation. Selling expenses on City Living are also relatively lower, suggesting added leverage on consolidated SG&A, while JV income has upside as TOL delivers on Pierhouse and The Sutton.

Up 4.2% over the past 12 months, Toll Brothers, which posted mixed second-quarter financial results last month, isn’t the biggest laggard among the big home builders. Hovnanian (HOV) has fallen 37% over the same span, while KB Homes (KBH) has fallen more than 12%.

Still, Toll’s has under performed the broader S&P 500 index, as well as rival D.R. Horton (DHI) and the iShares U.S. Home Construction ETF (ITB) and the SPDR S&P Homebuilders ETF (XHB).

Meanwhile, DHI’s efforts to drive higher unit appears to be working. For the 2015 fiscal year, the home builder expects to complete sales on 34,500 to 37,500 homes for $9.5 billion to $10.5 billion, up from this year’s 28,670 houses for $7.8 billion.

D.R. Horton jumped 2.4% to $24.

It’s been a good week for home builders. On Friday, the National Association of Realtor’s chief economist, Lawrence Yun forecast a surge in sales of newly built single-family homes to 624,000. Yesterday Toll Brothers (TOL) posted better-than-expected quarterly earnings. And since Friday’s close, the SPDR S&P Homebuilders ETF (XHB) and the iShares U.S. Construction ETF (ITB) have climbed 1.4% and 2.3% respectively

But it’s been a dim year for homebuilders. Compared to the start of 2014, the ITB is flat and the XHB has fallen roughly 4%, compared to a 10% gain by the S&P 500 Index.

As MarketWatch.com writes:

Well, investors have been fickle, as housing-market data have fluctuated from month to month. The Commerce Department said U.S. home-building permits in September were at a seasonally adjusted rate of 1,018,000, up 1.5% from August. But the revised August number of 1,003,000 was down 5.1% from the revised July rate.

As for housing starts, they rose 6.3% in September from August. And in August, the rate had dropped 12% from July.

That’s a lot of ups and downs. But the really good news was that September housing starts were up 17.8% from a year earlier.

While U.S. stock indices didn’t deliver big gains today, they did inch further into record-breaking territory amid corporate profits.

The Dow hit its 23rd record close this year, after gaining 39.81 points, or 0.2%, to close at 17,613.74

The S&P 500 climbed 6.34 points, or 0.3%, to 2,038.26, marking its 39th record finish of 2014. The Nasdaq Composite Index gained 19.08 points, or 0.4%, to 4,651.62.

No major economic-data reports were released today, though later this week investors will get handed a reading on retail sales in October and a preliminary gauge of consumer sentiment in November.

Investors also will get batch of quarterly earnings reports from retailers, such as Macy’s (M), Target (TGT) and Wal-Mart Stores (WMT).

Friday’s jobs report, which showed that U.S. employers added jobs in October, lifted stocks last week. The ongoing rally in equities has been attributed to the Federal Reserve, an improving economy and corporate earnings.

Norfolk Southern (NSC), Toll Brothers (TOL) and J.C. Penney Co. (JCP) are just some of the stocks moving during today’s market action: Here’s a rundown:

Toll Brothers rose 3.3% to $33.29 after the home builder posted better-than-expected revenue for the quarter ended Oct. Sales surged 29% to $1.35 billion, lifted by strong demand in the home builder’s West Coast division to top the $1.31 billion expected by analysts.

Leucadia National (LUK) has been among the worst performers of the S&P’s 85 financial stocks. Today, the shares gained 1.4% to $24.13 after Barron’s editor Andrew Bary referred to the company as “A Mini-Berkshire At a Bargain Price.” The stock has been hurt by low returns outside Jefferies, the investment bank it bought early y last year. Still, many of its other business arte valuable, including Berkadia, a 50/50 joint venture with Berkshire

How about the real Berkshire Hathaway (BRK.B)? Warren Buffett’s holding company rose 0.75% to $144.68 after it posted Friday a drop in profit tied to an investment loss. Still, results overall beat expectations as the company’s railroad arm and other units continued to ride a rebounding U.S. economy.

J.C. Penney dropped 5.6% to $7.38 after Barron’s writer Jack Houghwarned readers that the troubled retailer may have set unrealistic financial goals. At its Oct. 8 analyst day, Penney set a goal of $1.2 billion in earnings before interest, taxes, depreciation, and amortization, by 2017, or close to four times this year’s estimate. To get there, requires lifting sales at longstanding stores by 5.4% a year, boosting gross margins, and holding spending flat.

Norfolk Southern surged 2.6% to $115.89 after Barron’s writer Robyn Goldwyn Blumenthalweighed in bullishly on the stock amid merger talks within the railroad industry. Talks have circulated of a deal between Canadian Pacific (CP) and CSX (CSX) but fell apart last week. On Friday, hedge fund manager Bill Ackerman speculated that Canadian Pacific was could buy another rival. The next day, Blumenthal argued that regardless of Canadian Pacific’s intentions, Norfolk is the better bet for investor due to valuation and future growth opportunities.

McDonald’s (MCD) rose 0.3% to $95.13 Monday after the restaurant chain said its October sales held up better than expected with global sales dropping 0.5% in October to beat the 2.2% decline analysts were expecting.

Sotheby’s (BID) rose 4.8% to $41.36 after its third-quarter loss narrowed as the auction house benefited from lower costs and a higher tax benefit that offset a decline in revenue.

WhiteWave Foods (WWAV) dropped 3.2% to $35.75 after the food company reported a 34% rise in revenue during the third quarter, boosted by its Earthbound Farms acquisition and sales in Europe.

Home builder stocks have had their ups and downs over the last few months. But on Thursday, the sector collapsed like a faulty roof.

Investors were already skittish in the face of rising mortgage rates. But stocks are plunging across the board in response to disappointing financial reports released today by PulteGroup (PHM) and D.R. Horton(DHI).

Barrons.com has been cautious on the home builder sector for some time. Last month, we suggested avoiding the entire sector ( see Barron’s Take, “Don’t Bet the House on Home Builders,” June 25), arguing that the second half of 2013 could be difficult.

Borrowing costs have surged on expectations that the Federal Reserve will scale back bond purchases. The 30-year average fixed mortgage rate was 4.31% in the week ended today, up from a near-record low of 3.35% in May, according to Freddie Mac.

Homebuyers are rattled, contributing to a rise in cancellations and a drop off in traffic.

Home prices rose for the fourth straight month in July, according to the S&P/Case-Shiller index released today. It was just one more piece of evidence that the housing sector is on the rebound. But investors don’t seem to need the reminder — they’ve been bidding up homebuilder stocks for months in anticipation.

In fact, some stocks in the sector may be getting ahead of themselves, writes Barclays analyst Stephen Kim.

“It appears that we have reached that point in the rally when investors are pricing in a ‘best case’ scenario — and even then it is difficult to justify much higher valuations for the strongest homebuilders,” Kim writes.

Kim thinks that concerns about excess inventory in recent years will give way to “a surprising shortage of quality housing supply,” which should push prices higher.

“Despite robust demand, supply constraints will likely keep housing starts from growing more than 25% per year through 2015. Meanwhile, inventories of non-distressed homes for sale are at their lowest level since 1992,” Kim predicts. “This scarcity of quality homes to buy could drive prices up 5.0%-7.5% per year through 2015, causing nominal prices in 2015 to exceed levels reached during the housing bubble.”

But isn’t that good for homebuilders? Yes, says Kim. In fact, he raised his price targets on stocks in the sector.

And yet, the gains from this scenario are already priced into the stocks. Investors have piled into homebuillders in part because there aren’t very many other ways to play the housing rebound using traditional investments. “[A]n absence of large-cap ways to invest in the housing theme has driven valuations in the sector to uncomfortable levels.”

Kim lowered his rating on DR Horton (DHI), Lennar (LEN), and Toll Brothers (TOL) to Equal Weight from Overweight. Instead he recommends “swapping into the higher-beta names KB Home (KBH) and Pulte Group (PHM).”

About Stocks To Watch

Earnings reports, corporate strategies and analyst insights are all part of what moves stocks, and they’re all covered by the Stocks to Watch blog. We also look at macro issues, investor sentiments and hidden trends that are affecting the market. Stocks to Watch gives you the full picture of the U.S. stock markets, all day long.

The blog is written by Ben Levisohn, a former stock trader who has covered financial markets for the Wall Street Journal, Bloomberg and BusinessWeek.